Monday 3 November 2008

Broking research must adapt to prevailing conditions

In order to regain some of their lost credibility, researchers might want to try a different tack: instead of always telling customers just how much money they can make, analysts should also write about how much they can lose.

1 comment:

Guanyu said...

Broking research must adapt to prevailing conditions

By R SIVANITHY
3 November 2008

Analysts have had to take a bit of a roasting in the popular press recently, especially those who maintained their ‘buy’ calls on China steel maker FerroChina in August/ September when markets everywhere were crashing, the China story had long lost its lustre and the full extent of the credit crunch was becoming painfully obvious.

To be honest, it’s not just ‘buys’ on FerroChina over the past couple of months that have cost the profession a large slice of its credibility but also those on the Singapore Exchange (SGX), banks, property stocks - in short, anything and everything. As a learned observer noted recently, analysts were irrationally exuberant at a time when this was clearly not justified.

How to repair the damage inflicted on a profession that many view as being second-class to begin with, and is often made a convenient scapegoat when things go wrong?

In our view, the best way would be to admit that, in an environment fraught with uncertainty and one where volatility is likely to remain high for the next several months, setting one-year price targets may be of little use and the practice should be temporarily suspended.

(Research critics might well remark at this juncture that targets of any kind are of no use even when the environment is benign let alone uncertain, but in the interests of furthering this discussion we’ll leave aside such scepticism for now and assume that some targets are better than none.)

Now, because clients demand some visibility in terms of where prices may head, an appropriate compromise would be to replace the 12-month view with 3-month and 6-month targets with the qualifiers that the 3-month figure is a trading call while the 6-month number is for those with a longer time horizon.

In essence, this suggestion requires brokers to be adaptable and to abandon their current arguably outdated model if rapidly changing prevailing conditions justify it.

Some houses have already segregated their research functions into two - one side that generates day-to-day, short- term trading recommendations, and another which services institutional clients who presumably have a longer-term investment horizon. As a result, it may be argued that brokers have already adapted to differing research needs.

But it’s worth noting that some purely institutional houses have shortened their time frames (possibly in response to customer demand); in an ‘underweight’ on Neptune Orient Lines last Thursday, for example, JPMorgan’s target price of $1.10 and pessimistic outlook was not based on a 12-month view but six months instead.

More of the same would in all likelihood be well received by a market where sentiment can swing between the wildly positive and wildly negative in seconds.

A second feature is one we’ve written about many times before: namely, the need to expand greatly on the present brief treatment given to risk.

Investing is all about juggling risk against return but while analysts spend an inordinate amount of energy calculating target prices and highlighting the potential returns, there is usually very little attention devoted to the accompanying risk.

Cynics might argue that analysts are not in the business of alerting customers to possible losses but instead are paid to highlight potential profits - in which case undue focus on risk might jeopardise business.

But as the recent fiascos involving DBS’s High Notes and Lehman’s Minibonds show, understating or ignoring risk is enormously irresponsible and can have massive repercussions.

In order to regain some of their lost credibility, researchers might want to try a different tack: instead of always telling customers just how much money they can make, analysts should also write about how much they can lose.